Via Bill Evans:
Prospects for the Australian Economy; Markets; and Global Risks
As we contemplate 2018 there are a number of key themes that we believe will dominate economic and market developments. Our advice to customers throughout 2017 has been to expect Australia’s growth rate to likely be anchored below trend in both 2018 (2.7%) and slowing to 2.5% in 2019. That has contrasted with official forecasts (Reserve Bank and Treasury) which anticipate growth picking up to 3.25% in both 2018 and 2019.
We have recognised a solid ongoing boost to growth from non– residential construction; government investment (especially at the state level) and exports. However we are much more cautious than official forecasts on the consumer; residential construction and equipment investment.
Slowing household incomes
Signals from the December quarter national accounts are more encouraging for the official view. Household spending has been revised up from an expected 2.1% to 2.9% following the release of the December quarter national accounts. This picture of households has changed from “lacklustre” to “slightly below trend”. However this was associated with a weak savings rate of 2.7% despite a boost in nominal labour income growth to 4.8% for the year largely due to an extraordinary lift in hours worked of 3.5%. With hours worked increasing so rapidly, labour income growth should have been boosted further but was constrained by wages growth and a drift to lower paid jobs – non-farm compensation per employee remained flat in the December quarter to be up an insipid 1.8% for the year.
Labour productivity fell over the year with GDP per hours worked falling by 1% over the year and unit labour costs growth lifting to 2%. This adverse development in labour productivity is likely to temper the recent strong demand for labour we experienced in 2017. \
It is therefore our expectation that there will be a slowdown in the current break neck pace of growth in hours worked over the course of 2018 and into 2019. Weak wages growth and the drift to lower income jobs looks set to continue putting some downward pressure on growth in labour incomes. With the savings rate now probably at its lows, another year of below trend consumer spending growth can be expected.
New business investment lifted by 5.8% over the past year, a sharp turnaround from a 6.2% decline over 2016. Over the year, infrastructure work fell 1.2%; non-residential building advanced 12.3% and equipment investment spending increased by 8.4%.
Mining equipment investment lifted by 31% over the year, reflecting the final fit out of three major projects. It is more encouraging that non-mining equipment investment lifted by 6.2% over the year following a slowdown in 2016 partly associated with the uncertainty around the 2016 election. With another Federal Election due by May 2019 and even greater uncertainty associated with that election (conservative government was expected to win the 2016 election whereas the Labour opposition is comfortably ahead in the current opinion polls), we may start to see equipment investment run into some headwinds from the second half of 2018.
Dwelling investment contracted in 2017 by 5.8%. Based on the downturn in the trend in high rise approvals and a flat outlook for detached housing, we expect this downturn has further to run with the contraction accelerating into 2019. Oversupply and a marked slowdown in sales to foreigners are weighing on the outlook for residential building. House price inflation is disappearing. On a six month annualised basis, prices are now falling in Sydney and Perth and slowing in Melbourne and Brisbane.
The regulator’s macro prudential policies are restricting interest only loans and tighter guidelines for all new loans are slowing house prices and credit growth. In previous cycles the authorities have relied on raising interest rates to slow the highly cyclical housing market. This time, the same effect has been achieved by the regulator as banks have independently raised loan rates; foreign demand has slowed; and regulations have significantly squeezed the availability of credit.
Furthermore, the attractiveness of investment properties has diminished. Land taxes and lacklustre rental growth have tightened rental yields. Prospects of adverse tax changes in the event of a change of government are also impacting investor confidence. Most banks are predicting rate increases while the alternative government is planning to reform some aspects of investor taxes.
We expect a long extended period of flat house prices on a national basis with weakness particularly centred on the Sydney and Melbourne markets. This will represent a considerable change in the “atmospherics” around housing wealth and may weigh further on prospects for consumer spending.
Inflation below target
Inflation is also likely to remain benign holding a little below the bottom of the Reserve Bank’s 2–3% target band. In this regard we are in broad agreement with the Reserve Bank which is forecasting that underlying inflation will hold at 1.75% in 2018 before lifting modestly to 2% in 2019. Note that underlying inflation has held below the 2–3% target band in 2015; 2016 and 2017.
With underlying inflation likely to therefore register five consecutive years at or below the bottom of the target range it is reasonable to argue that Australia is experiencing a structural fall in inflation. Arguably, without the risk of overheating the housing market, interest rates would have been even lower in Australia in recognition of this structural fall and the disappointing progress in restoring inflation to the target range.
Interest rate outlook
We have been of the view through 2017 that the official cash rate will remain on hold in both 2018 and 2019. With rates on hold in Australia and the US Federal Reserve continuing to raise rates, Australia’s cash rate is set to fall below the Federal Funds rate by March. By end 2018, it is set to be 63 basis points below the Federal Funds Rate, and by end 2019, 112 basis points below the Federal Funds Rate.
Sustained period of negative Aus–US rate spreads
The US economy is operating with much less ‘slack’ in its labour market (unemployment rate of 4.1% compared to an estimated full employment rate of 4.5%) than Australia (unemployment rate of 5.5% compared to a full employment rate of 5.0%) but, to date, wage pressure has only recently emerged (three month annualised pace has lifted to around 4%).
Of most concern to markets has been the planned lift in government spending ($300 billion over 18 months) and the Tax Cuts ($1.5 trillion over 10 years) in the US. These policies are likely to boost the Budget deficit by around 2% of GDP providing a solid boost to demand when the economy is already operating at full capacity in the labour market.
We expect three 25 basis point hikes in March, June and September from the FED. That would see the USD/AUD yield differential in the overnight market contract to minus 63 basis points – a situation we have not seen since early 2000. A further two hikes are expected in the first half of 2019.
AUD/USD Bond Spread
Back in August 2017, Westpac had been forecasting that AUD cash rates would fall below the US Federal Funds Rate by around 40 basis points by end 2018. That, in turn, would drive the 10 year bond spread to zero, from around 60 basis points. At that time markets were priced for the US rate to be around 35 basis points below Australia. We now expect RBA rates to be even lower than Federal Funds at minus 63 basis points by end 2018 and minus 112 basis points by mid-2019. The likely result is that AUD 10 year bonds will trade around 30 basis points below US bond rates by mid-2019.
Commodity Prices; China; and the Australian Dollar.
Amid general euphoria around the global economic outlook we suggest caution. The Chinese economy is generally expected to slow as consumption and net exports are unable to compensate for the ongoing slowdown in investment. However, the big uncertainties and risks continue to centre around the Chinese financial system.
Much has been made of the synchronised lift in global growth in 2017. From Australia’s perspective the key development has been the faster than anticipated growth in China. China’s growth rate printed 6.9% in 2017 but we anticipate a decent slowdown in 2018 to 6.3%.
China realises that it must move away from its growth model based on exports and investment. In particular the role of the financial sector must change from channelling high savings at low cost to strategic sectors, to facilitating China’s economic transformation to a more sustainable model based on services and consumption. But the “old” model has resulted in financial assets growing from 260% of GDP in 2011 to 470% in 2016 (IMF, 2017). The excessive growth (around 30% per annum over the last 10 years) has been in the largely unregulated non–bank sector.
In November, President Xi nominated poverty; pollution and financial leverage as his key “challenges”. We expect that the slowdown in growth in the non-bank sector will weigh on commodity prices as speculators are squeezed for funding and local governments, in particular, are restricted in their access to funding for new infrastructure projects.
We are already seeing some evidence of this squeeze on the non– bank sector. Banks are no longer allowed to guarantee wealth management products; entrusted loans (corporates borrowing to lend to other corporates with banks operating as agents) have been banned; rapid growth in short term interbank funding has been slowed; and general funding for wealth management products is being restricted.
These forces are likely to weigh on iron ore and coking coal prices. Some lift in supply from Australian producers is also expected to lower prices. These atmospherics for commodity prices along with the widening interest rate differential are eventually expected to weigh on the AUD. We recognise that capital flows are also critical to the AUD’s prospects. In forecasting, we have endeavoured to accommodate any direct impact of capital flows that is not explained by rates and commodity prices.
We target AUD at USD 0.74 by end 2018 and 0.70 by end 2019.
Excellent summary. The only thing I’d add is it is too bullish on bulk commodity prices and as result not dovish enough regarding the RBA nor bearish enough on the AUD time frame for falls.